Go for growth or value in a global upturn?

Growth

Jim Hamel

Lead Portfolio Manager, Artisan Partners Growth Team

Jim Hamel, Artisan Partners

As the current bull market enters its sixth year, investors may wonder where to find growth in a maturing bull market. Valuations are richer than they were a year ago, but interesting growth opportunities still abound globally.

It is critical to never abandon valuation discipline. It can be tempting to try to capture 100 per cent upside in a strong bull market, but doing so can result in a portfolio of over-valued stocks that materially underperforms when the next downturn hits.

Investors can mitigate this risk by investing in franchises – firms with a combination of moat-like features protecting them from competitor encroachment, such as leading market share, material intellectual property, a defensible brand and/or a low-cost advantage. Once identified, it is important to buy franchises at reasonable valuations.

Finally, stocks follow profits. Regardless of the macro environment, if you can find where profits are likely to accelerate, you can find good growth opportunities. The following are several powerful global trends that have the potential to contribute to profit acceleration for well-positioned firms for some time.

Industrial process innovation: In emerging markets, wage inflation is driving up labour costs. In developed markets, consumers are demanding increased safety and quality. These factors, combined with a dearth of trained labour, are contributing to an increased use of smart industrial robots and automation – a new industrial revolution – as firms aim to increase quality, precision and output in a scalable manner while managing labour costs. For example Sweden’s Hexagon is a provider of design, measurement and visualisation technologies used to increase productivity and speed design engineering.

Biopharmaceutical innovation: Massive gains in the understanding of human genetics has shifted the biopharmaceutical industry towards increased development of new drugs that are often more effective, more targeted and less toxic. To reduce the ‘binary event’ risk that a firm’s only pipeline drug doesn’t get approved, consider firms with a strong current product cycle and a pipeline supporting additional waves of growth behind it. Regeneron Pharmaceuticals has a leading vision-loss treatment drug in Eylea and a pipeline of promising therapies for high cholesterol, allergic diseases and rheumatoid arthritis. 

Mobile internet: The proliferation of ‘smart’ devices is making cheap and powerful handheld computing commonplace.  Internet mobility is reordering a number of traditional industries including retail and media. Even business software has changed as firms shift to on-demand, flexible cloud-based software. Firms with exposure to this trend include Baidu, China’s leading internet search provider, which is focused on monetizing its mobile platform and increasing user engagement.

Golden age of natural gas: Technological gains in horizontal drilling and hydraulic fracturing has made extraction of hydrocarbons from unconventional sources economical, causing an energy renaissance in much of North America. IEnova, Mexico’s largest private pipeline operator, has assets strategically located near and interconnected to the US market, and it could benefit as Mexican energy reforms opens that market to private investment for the first time in over seven decades.

The rise of emerging market consumers: Emerging market incomes are rising, and a newly emerging middle class is demanding more and higher quality goods and services and increasingly spending on leisure activities. Great Wall Motor Co – China’s largest SUV manufacturer – has enjoyed particularly fat profit margins as Chinese consumers mimic US demand for ‘bigger-is-better’ vehicles.

Identifying strong franchises at reasonable valuations on the cusp of a profit-acceleration cycle can help investors find profitable growth where ever it occurs globally. 

Value

Nicolas Simar

Head of Equity Value Boutique at ING Investment Management

Nicolas Simar, ING Investment Management

Looking at value investing in a regional sense, the US recovery has seen a massive outperformance of growth and momentum, with value only starting to catch up recently. While value outperformance is already prevalent in Europe since mid 2012, if we look elsewhere in the G7, Japan continues to lag its peers.

 In Europe, over the last five years, quality has been given a growth premium and non-cyclicals have seen their weight increased within the growth style. The breakdown of sectors’ differences between ‘value’ and ‘growth’ highlights the dominance of food and beverage, healthcare and personal and household goods in the growth style. These are non-cyclical industries with low and stable rates of growth that make them vulnerable to a European recovery, even a mild one.

We expect the rotation from good quality growth towards value to continue in Europe as bond yields rise, while good quality growth companies still trade at an extreme valuation premium relative to value stocks, following five years of significant re-rating.

We do foresee some pressure on earnings revision trends. Companies concentrated in industries such as consumer staples, consumer durables and healthcare typically show underperformance versus the market in a rising rates environment, as their equity duration is significantly higher compared to the value side. They share, on average, a significant exposure to emerging markets which are typically the first casualties of rising US bond yields.

Rising bond yields are supportive to high dividends. High and sustainable dividend yields can be found in banks, insurance, energy, utilities, basic resources and the construction and material sectors.

Over long periods, value investing, of which dividend investing is largely a subset, largely outperforms growth. Value underperformance since 2008 is one of the longest episodes on record. However, we are starting to see a trend of corporates putting more emphasis on returns at the expense of growth and ultimately, shareholder returns. That means payout ratios and dividends should keep following an upward trend for years to come. Conventional wisdom states high dividend paying stocks won’t do well in an environment of rising long-term rates but this is not warranted by empirical and academic evidence. Indeed, there are different kinds of dividend paying stocks that don’t perform the same way in a given market environment.

While the statement above might be valid for the ‘stable/secure growth’ dividend payers such as consumer staples, there are also chunks of the dividend paying universe that should actually benefit from an economic revival and do well in a rising rates environment. Mostly, these stocks are to be found in the cyclical value/dividends sectors such as life insurance, some banks, parts of industrials and materials.

In Japan, we work under the assumption that ‘Abenomics’ will succeed at re-inflating the economy. There should be a material increase in corporate profits from a low base that should support the equity market and also translate into dividend growth. That will especially be the case for export driven companies, which will especially benefit from yen weakness induced by those policies.

Japanese payouts are still lower than in other regions, but awareness for shareholder returns is slowly improving, even if it hasn’t translated yet in markedly higher payouts and more generous dividends.